Monday, March 26, 2007

The Issue Of China's Relative Importance

When I recently participated in a seminar about a report in Financial Analysis authored by me and some other people, I ended up in a brief discussion with my teacher regarding a part of the report where I (I was the author of that part) argued that the entry of China in the global economy had contributed to increasing the difference in return between interest bearing assets and real investments. This is because China's purchase of western bonds have directly pushed down interest rates and the downward pressure on consumer prices through the influx of cheap Chinese goods have indirectly enabled central banks to keep short-term interest rates low. Moreover the increase in global labor supply through China's entry into the global economy have weakened worker's bargaining power and so contributed to rising corporate profits. This means that it is more profitable than ever to borrow more money for real investments.

My teacher argued that the Chinafactor was "overrated". In hindsight, my reply was unusually unsatisfactory as I am normally good at debates, but this time I left out the strongest arguments for my case. In that brief discussion I allowed myself to be dragged in a debate about China's present GDP at current exchange rates, which is the measure which gives the lowest estimate of China's economic importance. What I should have pointed out was that China's significance for the global economy is much larger than relative GDP at current exchange rates because 1) Because the yuan is so undervalued, real domestic activity is much larger than what current exchange rates apply. This is evident in the fact that China's commodity consumption is as big or bigger than America's. 2) China have a much larger foreign trade relative to GDP than for example America or Japan. China's goods exports surpassed Japan's in 2005 and will this year surpass America's. Already China is a bigger supplier of goods to the European Union than the United States (or anyone else), and will likely overtake both Canada and .the EU as a goods supplier to the U.S. in 2007.

When my teacher then asked of how long it will take for China to overtake America in GDP at current exchange rates, I made the mistake of quoting some calculations that I have read, estimating it to occur by 2040. Yet after having made some calculations tonight, I realize that that estimate is based on unrealistically low estimates of relative Chinese growth.

China's GDP was 20,94 trillion yuan in 2006, which with year end exchange rates was $2.7 trillion. America's GDP in 2006 was $13,24 trillion, meaning it was 4.9 times China's GDP.

In order for it to take as long as 34 years for China to surpass America, relative growth would have to be just 4.8%. Considering that growth currently seems to be about 10% higher in China and the 10-year average is nearly 7% higher, this seems unrealistically low. Moreover, this would also assume no real exchange rate appreciation. Another unrealistic assumption given the tendency for real exchange rates to rise in rapidly growing countries and given the strong external and internal pressure on China to revalue the yuan significantly.

The current 10% growth differential is unlikely to be sustained as China's growth is pushed up by cyclical factors, while America's is pushed down (so far only slightly) by cyclical factor, so the longer term 7% differential is more appropriate to uses in these calculations. And with the much more realistic assumption of 7% growth differential and a 5% real annual appreciation of the yuan relative the dollar, China would overtake America by 2020.

So, whether you like it or not (And there are good reasons to be both happy and concerned about it), China is one of the most important factors in the global economy today. And it will become the most important much faster than what most people think.

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